Corporate Governance Flashcards
Tirole’s Definition
“The ways in which the suppliers of finance to companies asssure themselves of getting a return on their investments” (2006)
General
System of checks and balances to mitigate agency costs.
Agency cost examples
- Insufficient effort
- Extravagent Investments
- Entrenchment Strategies
- Excess Risk Averseness
Insufficient Effort
Allocation of work time to preferred tasks or avoiding inconvenient but valuable activities => avoiding renogotiation of supplier contracts, thorough appraisals, admin stuff, etc
Extravegent Investments
Pursuit of pet projects and empire building at expense of less glamourous high NPV projects=> misaligned priorities
Entrenchment Strategies
Actions that hurt shareholders to secure own position
=> investing in specific technologies/assets that align w/ their expertise
=> enganging in M&A to increase complexity of firm to increase administrative burden=> more need for managers
=> Use of earnings management to manipulate firm perfomance, e.g. aggressive revenue recognition (e.g. Groupon/Tesco)
Self Dealing
Seeking personal benefit from business deals
=> Nepotism
=> making business decisions to maximise personal social capital instead of shareholder value
Excess Risk Averseness
Managers cannot diversify away specific risk like shareholders can=> all of their human capital tied to one firm
=> Shareholders only care about market risk but managers care about both specific and market risk so higher required rate of return for positive NPV projects
Enron
Became darling of wall street for integrating technology solutions and complex finance into the energy business
Unravelled after found using SPVs o conceal huge debts off balance sheet and understate leverage to Shareholders
Shares crashed=> shareholders paid price
Moral Hazard in Practice
Effective incentives for high performance:
1. Implicit Incentives
=> passive incentives not directly tied to compensation
- risk of firing
- threat of proxy fight/takeover as result of poor performance
- threat of bankruptcy
- product market competition
- Explicit Incentives
- bonuses=> tie compensation to performance=> encourages myopia
- compensation base=> provides salary insurance
- share options=> alternative to bonuses, aligns interests
What is Executive Compensation?
Describes salary packages of a companies exec managers
Bell and van Reemem (2013)
Wage inequality in developed economies may be driven by executive bonuses
Murphy (1999)
Cross-country, firm , industry and time heterogeneities
=> Exec compensation varies across countries/industries
Why is CEO Pay so high?
- Promotion tournaments
=> High pay for senior roles incentivise those in lower roles
=> Pyramid structures (e.g. Banks, Law firms…) - Signalling
=> High pay packages act as a signal of firm/employee quality
=> market assumes higher paid workforce = more productive workforce
=> also communicate healthy financial position and confidence in future cashflows, assume higher pay= higer capacity to pay - Not always true firms may leverage brand to pay less, lower pay may be signal of higher firm quality, wider benefits
- CEOs are highly skilled and uniquely fitted for their position low supply/high demand
- CEOs exposed to both market and industry risk
Bandiera et al (2017)
17% of CEOs misplaced for the job
=>CEOs affect firm performance but they are not irreplaceable
Jenter and Kanaan (2015)
Data from over 3000 CEO changes between 1993 and 2009=> strong evidence for high turnover
=>CEOs are punished for industry/market performance
Hirschman (1970)
Exit and Voice: 2 broad approaches to corporate gov
- Exit - Anglo American=> shareholders sell if unhappy
- well developed stock market
- substantial disclosure requirements, transparency requirements
- shareholder activism
- Proxy fights, group of shareholders consolidate votes to drive agenda
- takeovers - Voice German/Japanese=> work with management
- Trust between managament and Shareholders
- Cross shareholding among firms/between firms and banks
Exit - Drawbacks
- encourages myopia
=> managers focus on short run profitability to avoid share sellout
=> no cohesive vision between mangement and shareholders - Limits amount of trust between management and shareholders
Voice - Drawbacks
Limited Productivity=> reduced firing risk, less incentive for high effort (not compelling, more enlightenment and potentially more freedom to lead)
Stock market liquidity falls, investors have long time horizons
Shareholder have less leverage, may exacerbate agency issues driven by CEO hubris (Like empire building, etc)
Does M&A add value?
Grossman and Hart (1980): Takeover bids only successful only if they offer at least full value for the target
=> atomistic shareholders have no impact on final bid price=> still recieve any post takeover value gain if they don’t tender offer but others do
=> no incentive for them to accept any offer below FV
Does M&A add value? Toehold Purchases
Toehold purchases = purchase of small % of target company for announcement 5% in US, 3% in UK
=>allows acquirer to get a stake of firm before disclosing intent to make formal bid
=>after disclosure price rise in response so only small gain (unless firm possesses some private info)
Synergies
When Value to acquirer is larger than book value of target
1. Economies of scale => why firms tend to consolidate during downturn, efficiency gains allow for cost savings
- coplimentary assets may create value greater than sum of parts (Teece 1986)
- More capacity to leverage tax shield=> for tax capital intensive industries (construction, energy, utilities)
- Human Capital Benefits - access to more effective management
Takeover Defences
Protection measures to prevent predation of “cheap” undervalued firms.
=> generally pushed by incumbent management and local politicians
can be viewed in 2 ways:
1. create value for existing shareholders by forcing bid price up
- provide excess security for inefficient/incompetent managers and board members
Takeover Defences - Poison Pill
Specially designed shareholder rights plan
=> Gives shareholders of target option to buy stocks of target/acquirer at a discount in case of successful takeover
=> can be set up quickly and without shareholder approval
2 types:
Flip in: Target issues new shares to shareholders at a deep discount=>instant profit for shareholder’s
=>dilutes shares held by acquiring, raises cost of TO
Flip over: Target shareholder’s have option to buy bidders stov at discount post-acquisition
=>drives down share price of bidder
